Limited liability creates a conflict of interests between policyholders and shareholders of insurance companies. It provides shareholders with incentives to increase the risk of the insurer’s assets and liabilities which, in turn, might reduce the value policyholders attach to and premiums they are willing to pay for insurance coverage. We characterize Pareto optimal investment and premium policies in this context and provide necessary and sufficient conditions for their existence and uniqueness. We then identify investment and premium policies under the risk shifting problem if shareholders cannot credibly commit to an investment strategy before policies are sold and premiums are paid. Last, we analyze the effect of solvency regulation, such as Solvency II or the Swiss Solvency Test, on the agency cost of the risk shifting problem and calibrate our model to a non-life insurer average portfolio.

Under the agreements reached today, the minimum requirement for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The Tier 1 capital requirement, which includes common equity and other qualifying financial instruments based on stricter criteria, will increase from 4% to 6% over the same period. (Annex 1 summarises the new capital requirements.)

The Group of Governors and Heads of Supervision also agreed that the capital conservation buffer above the regulatory minimum requirement be calibrated at 2.5% and be met with common equity, after the application of deductions. The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. This framework will reinforce the objective of sound supervision and bank governance and address the collective action problem that has prevented some banks from curtailing distributions such as discretionary bonuses and high dividends, even in the face of deteriorating capital positions.

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

These capital requirements are supplemented by a non-risk-based leverage ratio that will serve as a backstop to the risk-based measures described above. In July, Governors and Heads of Supervision agreed to test a minimum Tier 1 leverage ratio of 3% during the parallel run period. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

To wrap up: Bailouts will inevitably happen during financial crises to prevent runs and systemic collapse. We need to structure financial regulation so as to limit the size and occurrence of these bailouts. How should we best design such regulations? The social distortion we face is that debt guarantees create a risk externality, because financial institutions do not bear the full costs of their investment choices. Financial regulation should be designed so as to best control that externality. As is true with any externality, the risk externality can be eliminated with a well-designed tax system. Figuring out the right tax may be complicated, but the task can be eased using appropriate information from financial markets.

Abstract: A belief that markets are efficient is blamed for instigating the crisis we are in and lulling us into complacency as the crisis was approaching. But the debate about the role of such belief in the crisis is unfocused for two reasons. First, a lack of a common definition of market efficiency precludes a common language. Second, efficient markets are conflated with free markets.
The ambitious definition of efficient markets is their definition as rational markets, where security prices always equal intrinsic values. The modest definition of efficient markets is their definition as unbeatable markets. Bubbles cannot occur in rational markets but they can occur in unbeatable markets. I argue that a belief in market efficiency cannot bear responsibility for our crisis since most investors do not believe that markets are either rational or unbeatable.
Free markets are markets where government puts little or no imprint on the financial behavior of individuals and organizations and on markets through regulations and direct intervention. Many advocates of free markets believe that such markets are also more efficient than markets which are not as free. But free markets are distinct from efficient markets. Highly regulated markets can be no less efficient in the sense of rational markets or unbeatable markets than lightly regulated markets. I argue that a belief that free markets are always superior to regulated markets and lightly regulated markets are always superior to heavily regulated markets does bear some responsibility for our crisis. Regulations that would have limited the types of mortgages offered to homeowners would have helped stem the crisis or mitigate it. So would have limits on the degree of leverage employed by banks and homeowners alike.
Yet not all regulations and government interventions bring unmitigated benefits. We have no precise measures by which we might distinguish real bubbles from illusory ones. Governments which aim to pop real bubbles run the risk of plunging us into recessions by popping illusory ones. While high P/E ratios and similar measures might alert us to the presence of real bubbles, they are far from precise. The challenge we face is the challenge of seeing an opaque future as clearly as possible, knowing not only that foresight is not as clear as hindsight but also that we would be judged in the future as if it is.